Student Loan Refinancing Versus Federal Direct Loan Consolidation
Historically, the focus on debt consolidation has been around consumer debt e.g., credit cards and other non-secured personal debts but there has been an explosion of student loan debt over the past decade, with total student loans now exceeding all credit card debt in the US!
In general when discussing consumer debt management, terms like consolidation and refinancing are often used interchangeably, as the act of consolidating multiple loans into one typically involves the action of refinancing them (taking out a single new loan with new terms and using the proceeds to repay and replace the old loans with less favorable terms).
Accordingly, this massive growth in debt has led to similarly massive growth in refinancing and consolidation programs specifically for student loans, including traditional lenders like Citizens Bank to alternative lenders like Earnest, and new non-bank marketplace lending alternatives like CommonBond and SoFi
However, when it comes to student loans, there is actually a difference between refinancing (which may include consolidation of many loans into one) versus just consolidating multiple loans into one, thanks to the Federal Direct Consolidation Loan program.
The Federal Direct Consolidation Loan combines together multiple Federal student loans into a single loan. This process of consolidation does not actually change the interest rate being charged (aside from a miniscule adjustment that may occur because the consolidated rate is recalculated as the weighted average interest rate of all the individual loans being consolidated rounded to the nearest 1/8 th ). However, a Federal Direct Consolidation Loan can stretch out payments over a longer repayment period in some cases.
More important, though, a Federal Direct Consolidation Loan can render the student loan borrower eligible for several flexible repayment programs only available for certain Federal student loans.
— Income-Based Repayment (IBR). With IBR, payments are capped at 15% of the borrower’s discretionary income, and can be as low as $0 for those below 150% of the Federal poverty level. Any excess interest is capitalized, with no maximum limit on negative amortization, but any remaining balance is forgiven after 25 years (this was reduced to 20 years and a 10%-of-income cap for recent borrowers since ). To qualify for IBR, the borrower must have a partial financial hardship (in addition to otherwise being eligible).
— Pay As Your Earn (PAYE). Under PAYE, a student loan borrower’s monthly payments are capped at 10% of discretionary income (and can even be recalculated down as life and circumstances change), and again excess interest ortize) in some circumstances (but is capped at up to 10% above the original principal amount). Also similar to IBR, if the borrower still has a balance after 20 years of payments, the balance is forgiven (though the forgiven amount is taxable as income, unless specifically part of the Public Service Loan Forgiveness program described below). Notably, PAYE is a more recent program and older student loans may not be eligible for PAYE (unless consolidated, as discussed below!).
— Revised Pay As You Earn (REPAYE). The newest Federal loan program, which just became available in , REPAYE has terms similar to PAYE, where monthly payments are again capped at 10% of income, and again allows forgiveness after 20 years (for undergrad, 25 years for graduate school). Unlike PAYE, though, negatively amortizing interest charges with REPAYE only accrue at 50% of the unpaid interest, and only capitalize if you leave the REPAYE program.
The PSLF program, which can apply on top of any of the aforementioned programs, turns a forgiven loan from a taxable event into a non-taxable one
— Public Student Loan Forgiveness (PSLF). In addition, loans can be forgiven after only 10 years of payments (technically, after making 120 qualifying monthly payments). Notably, though, as the name implies, PSLF is only available to those who work (full-time) in the public sector, which generally means working for the government (Federal, state, or local), a 501(c)(3) charity, or certain other qualifying non-profit organizations.